Accrual Concept is a fall-out of Accounting Period concept. This concept requires that expenses incurred for a particular accounting period should be reckoned in the same period, irrespective of the fact whether these expenses have been paid in cash or not in that year. The same holds true for revenues, i.e., revenues earned in a specific accounting period are construed as incomes of the same period, irrespective of their receipts. This concept is also known as the accrual theory of accounting or accrual accounting. This concept applies equally to revenues and expenses. In the accrual basis of accounting Revenue is recognized when it is realized, that is, when the sale is complete or not.
Similarly, the expenses are recognized in the accounting period in which they assist in earning the Revenues, whether the cash has been paid for them or not. Recognition of revenues and expenses for the income determination, therefore, does not depend upon the time when the cash is actually received for expenses or paid for expenses.
The essence of revenue is that a mere promise on the part of a customer to pay the money for the sale or service or Interest, Commission, Rent etc. in future is considered as Revenue. Similarly, a promise on the part of the business entity to make payment for salaries, rent etc. ion future is considered as an Expense. Income (excess of Revenue or Expenses) is associated with the change in the owners’ equity and that is not necessarily related to changes in cash.
A business entity may sell goods for $20000 on December 25, 2004 and the payment is not received until January 25, 2005. The sale of goods would result in an increase in the assets (debtors) of the firm of $20000 and increase in the capital by the same amount (of course to be reduced by the cost of the goods sold) although no cash has been received. However, when the Cash is received on January 25, 2005, this would not result in Revenue. It would result in increase in one asset (cash) and a decrease in another asset (debtors). Similarly expenses and cash payments are not the same because a distinction is made between Capital and Revenue Expenditures.
Other Examples of Cash Payments which are not expenses include purchase of a machine for cash (an increase in one asset - machine and a decrease in the other asset - cash), the payment of creditors and so on.
Thus, we can say that the accrual concept makes the distinction between the receipts of cash and the right to receive the cash and the payment of cash and legal obligations to receive cash, because in practice there is usually no coincide3nce in time between cash movements and legal obligations which they relate.
The justification for the accrual concept is that earning of revenue and consumption of a resource (expenses) can be accurately related to particular or specific accounting period. This would enable the measurement of Income of matching expenses and revenue. The drawbacks include:-
i. The apportion of expenses to different time periods is a time consuming process and ii. Financial statements become more complex for the layman who may find it difficult to understand the difference between the actual receipt of cash and the right to receive the cash and also the actual payments and the obligation to pay.In other words the inclusion of prepayments and inclusions in the Balance Sheet may not be understood easily In the absence of Accrual accounting, the Income Statement may indicate more profit in one year at the cost of the profits of some other year, which is entirely inappropriate and illogical. In other words, cash basis of expense recognition will hamper comparison of profit figures over the years. Clearly, there is a very strong case for a business firm to adopt accrual basis of accounting, known as Accrual accounting to determine correct profits. What holds true for expenses, the same holds true for revenues. Revenues...
Please join StudyMode to read the full document